How the euro was saved

With a bang, not a whimper

IT IS always darkest before August. When policymakers head on vacation, risk-takers put their optimism on ice, retreat to cash, and leave markets to find their own level.

That’s how it’s looking in Europe anyway. Spain may be on the verge of losing market access. Any warm feelings its government generated with last week's new round of austerity were quickly washed away by mounting bad news on the economy, its regions’ finances, and its banks. European leaders, having announced plans to strengthen the European Stability Mechanism (ESM), can’t act on them until Germany’s constitutional court rules on their legality on September 12th. The European Central Bank remains on the sidelines.

It is easy to envision a downward spiral that results in multiple countries leaving the euro amidst a financial and economic meltdown. It is almost impossible to envision the opposite. But somebody has to.

In May, Peter Berezin of the Bank Credit Analyst adopted the viewpoint of someone looking back on the crisis from the year 2021, and described what today must seem like a hopelessly idyllic outcome:

In the end, the common currency survived. Indeed, over the past five years, growth has accelerated sharply and debt levels and borrowing spreads have continued to come down… While it was hard to imagine during the dark days of 2012, European stocks have outperformed all other major markets over the past decade.

How did Europe get there? The reports of BCA, a Montreal-based research shop, stand out for how incisively they diagnose the causes of the euro crisis and the plausibility of the scenarios they sketch for its resolution. Mr Berezin's June report accurately pinpoints the source of the crisis: persistently higher inflation and slower productivity growth in the periphery led to growing current account deficits with Germany. Ordinarily, such deficits are solved by devaluation. In a monetary union that's impossible; it requires either prolonged deflation in the periphery, systematically higher inflation in Germany, or default—either explicit, or via euro exit.

It is fear of this last outcome that is driving the periphery's vicious circle of rising bond yields, austerity, recession and deficits. Breaking that circle requires restoring risk-free status to peripheral government debt. That could be done via explicit debt mutualisation through Eurobonds (ie, Germany is on the hook for Italy’s debts) or the European Central Bank, with its unlimited buying power, becoming lender of last resort.

In Mr Berezin’s telling, things had to get much worse before they could get better. In the fall of 2012, Greece abrogated its bail-out agreement with the IMF, European Union and ECB, declared a moratorium on all external debt payments, and began paying domestic bills with IOUs that it then declared legal tender. The ECB cut off Greece’s banks, Greece responded with capital controls, and relabeled its IOUs “new drachmas” which quickly plunged to 35 euro cents. Bank runs immediately commenced throughout the periphery; bond yields in Spain shot over 7%; global stockmarkets cratered.

The ECB was finally forced to act to save the euro: it announced it would buy as many bonds as necessary to cap all sovereign yields at 6%, with the exception of Greece. The ECB never had to buy any bonds: investors no longer had any reason to sell since the ECB had taken insolvency off the table.

Just as important as the market consequences of the ECB actions were the macroeconomic ones: they succeeded in pushing inflation sharply higher in Germany, enabling the periphery to recover competitiveness and balance their current accounts. It was striking, Mr Berezin's writer from the future reflected, how complacent markets were about inflation in Germany in 2012: indexed bonds were forecasting inflation of 1.2% while unemployment was at a 20-year low, home prices were rising, and unions were negotiating fat wage increases. Many were so fixated on Germany’s reputation for monetary discipline they had forgotten its temporary bouts of inflation, most notably in the early 1990s. Higher inflation was “the price that West Germany paid for reunification. As it turned out, higher inflation was also the price that Germany paid for preserving the euro zone.”

A lot has happened since that was written in May. For one thing, Spain’s yields are now well over 7%. Earlier this month Dhaval Joshi of BCA issued an update. The key development, he writes, is that at the European summit last month, leaders acknowledged their monetary union won’t work as currently structured and they commited themselves to creating a fiscal and banking union (though not in so many words). But how? Eurobonds would require multiple treaty changes and take too long. Mr Joshi acknowledges the ECB’s opposition to large-scale bond buying “is almost religious”. Though soon able to buy sovereign debt, the ESM's firepower is limited to €500 billion. That problem would be solved if the ESM became a bank, giving it access to unlimited ECB liquidity. That's what Mr Joshi expects.

Today Ewald Nowotny, head of Austria’s central bank and an ECB council member, told Bloomberg he saw arguments in favour of giving the ESM a banking license. “There are also other arguments, but I would see this as an ongoing discussion.” It is too soon to say that Mr Nowotny’s remarks are a turning point; the ECB and Germany have previously opposed making the ESM a bank and lender of last resort. Even if that opposition is weakening, breaking it down altogether will take time that Europe may not have. Mr Joshi concludes the markets may have to riot more before policymakers take the necessary step. The time to buy European stocks and peripheral bonds isn’t here yet, he says: but he thinks it will arrive in the next 12 months. Is this possible? Perhaps. Is it optimistic? Definitely. So keep it in mind: it may help you through the dark, hot days ahead.

You make some good points, but one must also be fair in considering the situation from the point of the German taxpayer.

The *real* problem here is that the good will of the German taxpayer was squandered on Greece, where the problems were largely the result of gross profligacy, lack of tax compliance, and falsified national accounts. Greece then proceeded to further alienate the German taxpayer by playing the "World War 2 card" and by demonising Germany (e.g. photoshopped pictures of Angela Merkel in Nazi uniform). Political opportunists tried (and are still trying) to scapegoat Germany for the country's self-made problems.

Is it any wonder than the German taxpayer has had enough of this?

Although one can point fingers to other countries (Spain's wasted spending for regional development, France's delusions of retiring at 60 while Germans work until 67, Italy's long-standing massive debt, etc.), none of this is anywhere on the scale of Greece.

I see figures that the total tab for the Greek bailout is now up to EUR 320 billion (don't know if this is exactly correct, but it's something on this order) - which against a working-age adult population of about 7 million works out to about EUR 46,000 per working-age Greek. This is jaw-dropping.

Yes, you're right that austerity is counter-productive here, but the unfortunate reality - and the crux of the problem - is that deficits need to be financed, and the sources of finance (particularly the German taxpayer) have already been blown on Greece.

The ECB was finally forced to act to save the euro: it announced it would buy as many bonds as necessary to cap all sovereign yields at 6%, with the exception of Greece. The move was immediately challenged by a group of German economists led Ifo's Hans-Werner Sinn as a fragrant violation of the treaty establishing the ECB. The Federal Constitutional Court announced that the soonest it could issue a ruling is in six weeks. In the meantime the ECB began buying bonds through the existing SMP facility.

Although the German high court was known for its restraint, commentators did not have high confidence that it would allow the plan to move forward. The language of the EU treaty plainly forbid it. Moreover, German public opinion was decidedly against the proposed rescue. Adding to the confusion, both the FDP and CSU left Merkel's government in protest, forcing her to form an uneasy grand alliance with the SPD.

Given the uncertainty as to whether the ECB would be allowed to continue bond purchases, investors began to view SMP as a small window of opportunity to minimize their losses. "Get out before the money runs out" became the maxim of the day. Through heroic efforts the ECB was able to hold the yields on Spanish and Italian bonds at under 6%. Yet rather than calming the market, its rapidly swelling balance sheet only prompted more selling. As a German ECB board member noted after his resignation, the bank was simply lending into a run. Many of his countrymen agreed. A public opinion poll showed that a stunning 70% of Germans want a return to the Deutsche mark.

Citing the heightened probability of a euro break-up, Standard & Poor's and Moody's lowered the bond rating of Italy to junk status. France and Belgium's ratings lost two notches. Even Germany's cherished triple-A was taken away. Investors began to flee to the safety of the US dollar. The EURUSD exchange rate fell through the $1.00 barrier for the first time in ten years. The ECB asked for the Federal for help to ease the dollar crunch at European banks. Bernanke was unwilling, however, to commit American money in such large quantity without the backing of the political branches. GOP in the House promptly passed a unbinding resolution against it. The White House, focused on the upcoming elections, merely advised the Europeans about the need for a more "perfect union" and did nothing.

So let's just stop and note: Germany's right wing politicians and bankers, as well as the then right-wing President of France, promised that austerity measures imposed on the citizens of the peripheral countries like Greece and Spain would fix everything. Instead it's been a complete disaster, and the economies of these countries just contracted more and more, as the entire continent slid into recession. Again. Since lack of demand was the problem all along, the idea that impoverishing the population and thus reducing demand even further would improve things was always a complete fantasy, and historians will spend decades trying to understand what was going on these people's minds at the time. What they'll find is a tangled mess of political beliefs, trickle-down fantasies and faith-based economics, all supported by conservative magazines pushing the same false narratives until they began to realize that it had all been nonsense, as they then start covering the disaster it caused.

Let's just be clear: There were those who said that if austerity were imposed the way it has been, that this would be the result. There were others defending austerity who promised that it could never lead to further contraction. The former were right, the latter were wrong, and yet there are still those trying to defend the pro-austerity view and blame what's happening on "socialism".

Spain had a surplus, not a deficit, before this crisis. It didn't have massive government debt, because it had virtually none. Can you spin your "spending by socialist governments caused the crisis!" theories while taking that simple fact into account?

The answer is no.

There is no question that there were underlying problems, particularly in Greece. As to what led to this becoming the complete disaster Europe-wide, and now likely worldwide, that it has, this is the fault of the fantasy-based policies pursued ever since.

You can either admit that or ignore all of the evidence and continue in denial, which is what most will continue to do. The answers are there, you just don't want to see them.

If someone promised me that they would allow me to borrow at six percent, no matter what, I would borrow infinite money and just keep rolling it over. So precisely what measure is there to keep fiscal discipline in this alternate reality, smart stuff.

This would be the best solution for us in Italy (and Spain and France...)

Our debt would remain denominated in Euros. Without Germans we would be free to print a few more Euros, as the UK and the US have done (notice that inflation in both countries is just over 2%, hence the hyperinflation-doomsayers were wrong). And we would be free to let the euro slide in value to dollar parity, for example.

I am sick and tired of Germans who think that 4% or 5% inflation would be the end of the world. Greece is the first country to enter the deflationary spiral - and we are all following. This is insanity.

"Ooooooohhhhh, without Germany the Euro would be worth nothing and the ratings of Euro-bonds would be considered less than investment grade."

Arguments that hold absolutely no water with us in the South - the idea that Spain and Italy should be rated one step above junk status is ridiculous. We would be UPGRADED one month after a German exit - not downgraded.

I think we are still missing the point.
The problem is not the Euro, the Eurozone, not even the European Union.
We are in a deepening global crisis, what is happening in Europe is just the most acute symptoms of the disease.
The problem is we stubbornly want to push on with an illusion that a constant quantitative growth economic model in a closed finite system is possible.
Over 90% of today's products are simply obsolete, have nothing to do with a normal, comfortable, modern human life in the 21st century.
All our production and consumption is based on tricking people into fulfilling artificially generated desires for things we never even dreamt we would need.
This is totally unnatural while we live in a natural system we are part of. We cheated our way up to this point but now we have run into a wall.
First we have to fix the foundations based on the understanding of this closed, global, interdependent system we exist in and then everything else will fall into place.
If we keep tinkering with the superficial makeup we will sink so deep in crisis that there will be no way out.

The article speaks of PRODUCTIVITY GROWTH (NOT GROWTH, as you misread it):

"The source of the crisis: persistently higher inflation and slower productivity growth in the periphery led to growing current account deficits with Germany."

And that's precisely why Southern Europe is in the ditch right now, and why getting out of it takes more than a few budget adjustments here and there, but a sustained 10-20 year effort in all fields, beginnig with education and ending with producing more high-end products.

Your productivity will have to grow faster than Northern Europe's for YEARS in order to catch up - otherwise, the gap will keep widening, and the survival of the common currency be even less likely than it is now.

So what? They were double that level in the mid nineties. Nobody called doom because of that back then. All around the place everybody suddenly claims that 10yr yields of 7% and more are unsustainable (and uses this as argument for further mutualisation and socialisation of legacy debts).

However, in the past a lot of EMU countries had to pay much higher interest rates, and back then there existed no such 7% barrier. Why now?

Plus, during the de facto eurobond years with the unjustified low yields for the GIPISFs, they could via rolling-over of maturing debt and despite taking additional loans significantly reduce their debt service ratios. According to ‘Schulden ohne Sühne?: Was Europas Krise uns Bürger kostet’ by Prof.Kai A. Konrad and Holger Zschäpitz, in Spain and Ireland the debt service ratio went down from 10% in 1997 to 5% in 2007. In Greece from 25% to 10%!

Even if the yields for 'fresh money' since went up to more justified levels, the ratios should still be much below their spikes around ’95. And, consequently, be easier to serve.

Except, of course, if the GIPSIFs irresponsibly replaced the interest payments by even higher other costs like, for instance, inflated public sectors, generous pensions and so on.

But such behavioural idioticy can't be cured by any amounts of money injected by the ECB, German taxpayers, or the United States Of the Moon.

So, bottomline: this laughable doom-mongering about the 7% barrier serves a purpose. And considering who bungas this drums, the purpose is NOT to the best of main street people.

It seems Germany is like a hostage. Either Germans pay the price of inflation or mutual-bond or any other things, or they die together. But those felons will walk freely out of the scene after they receive what they want. This is plainly terrorism. West Germany paid for the pain of reunification simply they are brothers and sisters. While the periphery shares no blood with Germany at all. This is plainly terrorism. You pay or we die together.
No negotiation with terrorism. Money for duty. That's the only solution.
USA took the pain of losing its twin towers in Manhattan and commenced war with terrorism. Germany has much less to lose than that to start the same war against shameless threaten from terrorism of dying together.

Let's break down your socialism claim for a second- The leading parties in Greece and Spain called themselves socialist, but were actually centrist. Besides, socialism is worker control of the economy, and no noe did that. Ireland pulled off your whole "deregulate everything and the invisible hand will keep the dream going" idea and now their debt/GDP ratio in EU banks is 1100%. Italy was under a conservative and they're also headed for collapse.
Next off, labor law liberalizing has NEVER worked- if you literally destroy consumer purchasing power by extreme wage lowering which all neoliberals assert aids growth, but doesn't. Wage depreciation leads to lack of demand, and the only reason that labor laws obstruct growth now is because neoliberal success is measured by profit, and if you lower wages, you get more profit. This isn't about people, it's profit. When ethics becomes a thorn in your side, you know your system is unnatural, and artificial.
Slashing benefits is another mater of ethics v. false measures of success. slashing benefits comes at the same time as your wage slashing and liberalization, then you have unemployed and retirees with no money or means of gaining money. They have no means of gaining money because the fall in output caused by your consumer purchasing power depression has led to layoffs and is stopping hiring.
Next, selling government owned businesses depreciates government revenue AND lets business fall into the hands of those who would lower wages (private companies, plus your labor reforms) which leads to continued fall in demand, leading to fall in output. Your system is failing.

All well and good (and the story could be shortened to 'Germany caved'), but what happens if / when a voter revolt throws out Merkel and puts a right wing isolationist in place instead, who chooses a German euro exit over a decade of inflation?

"it requires either prolonged deflation in the periphery, systematically higher inflation in Germany, or default—either explicit, or via euro exit."

Whether you call it Eurobonds, ESM banking license, or else, it's ultimately about inflating the debt away. (and deflating any savings at the same time)

Too true. Higher inflation in Germany means fleecing Germany, asking Germany to pay for the profligate habits of others. Why does everybody seem to think that could be acceptable to the German populace?

The recent Spanish bank bailout was passed without a government majority. Even the centre-left parties are slowly reneging on Eurobonds and more debt-mutualisation - not because they changed their beliefs, but for one reason only - the Germans are getting restive, and the scrambling for position (September 13 election) has all but begun.

I think you started your comment right. You don't know much about "Socialists" and you don't know much about economics either. It is just the logical consequence of these facts that you missed. Nest time keep your prejudices for yourself.

"Mr Berezin's June report accurately pinpoints the source of the crisis: persistently higher inflation and slower productivity growth in the periphery led to growing current account deficits with Germany."

Current account deficits were a symptom not a cause. Berezin clearly has no clue as to what caused the crisis. Did current account deficits cause the state fiscal deficits?

The main cause of the fiscal deficits was 1) the recession and 2) socialism; states have kept their unsustainable socialist policies alive for a decade through borrowing, just as the USSR did before its collapse.

Socialism caused the low productivity growth, too, because most large businesses are state owned, or the state controls them through regulation and rigid labor laws.

Most of the Big EZ South's problems could be solved in a year or so if they would junk their labor laws and government benefits they can't afford, and sell of state-owned businesses.

I can't say I know enough about the politics or economies of EuroLand to say yay or nay to the BCA scenario but I begin to believe that the Socialist politicians of Europe are winning against the economists of Germany. I think it is possible that Germany may leave the Euro rather than be forced to backstop the reckless spenders. France is actually the next prospective basket case and that will be the real test of Germany's attachment to the Euro. I can't say how that will fall but if Germany caves in they must know that leaders like Hollande will abuse any freedom they are granted because Socialists don't understand that their economic ideas don't stand up over time. Spend, baby, spend. What can happen?

You do realise that productivity is measured through the product (GDP) right? It's not about productivity growing faster its about labour costs being adjusted to productivity. If less productives countries got more productive that just means they are becoming richer, not necessarily more competitive.

I think you should follow your own advice and stay clear off economic topics.

Poor Adam Smith. Like Karl Marx; Smith never finished the play. What happens once you win. There are gluts in almost everything. Shortages are being engineered. The emperor has no clothes, nor does he want any. The corporations have no demand and all the wealth.

They hold all the cards. They control population growth and population intelligence. They are faced with having to make us all stupid or exploit their wealth to make everyone's life better. Why wouldn't they do the latter. The benefits of elitism, they fear, would have to be shared. This shame they cannot face.

Those holding nothing have the power to self-educate but they have never been weaned as the co-dependency has been so comfortable for so long. The rich need some poor; just no so many that they have to "work" at keeping them busy.